Introduction to FIN 48: Accounting for Uncertainty in Income Taxes ACCT 70053 Spring 2008 Scope • FIN 48 applies to “all tax positions accounted for in accordance with Statement 109.” Tax positions • Tax position refers to a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. • A tax position can result in a permanent reduction of income taxes payable, a deferral of income taxes otherwise currently payable to future years, or a change in the expected realizability of deferred tax assets. Tax positions The term tax position also encompasses, but is not limited to: • A decision not to file a tax return • An allocation or a shift of income between jurisdictions • The characterization of income or a decision to exclude reporting taxable income in a tax return • A decision to classify a transaction, entity, or other position in a tax return as tax exempt Tax positions When a position is taken in a tax return that reduces the amount of income taxes paid to a taxing authority, the enterprise realizes an immediate economic benefit. • Considerable time can elapse before the acceptability of that tax position is determined. • FIN 48 requires the affirmative evaluation that it is more likely than not, based on the technical merits of a tax position, that an enterprise is entitled to economic benefits resulting from positions taken in income tax returns. • If a tax position does not meet the more-likely-than-not recognition threshold, the benefit of that position is not recognized in the financial statements. Tax positions Examples: • Company A deducts certain costs in computing taxable income. The relevant tax law is ambiguous and the deduction may be disallowed. • Company B deducts certain costs in computing taxable income. The relevant tax law is ambiguous and the company may be required to capitalize the costs. Tax positions In principle, the validity of a tax position is a matter of tax law. • When the degree of confidence is high that that tax position will be sustained, it is not controversial to recognize the benefit of a tax position in an enterprise’s financial statements • In some cases, the law is subject to varied interpretation, and whether a tax position will ultimately be sustained may be uncertain. Recognition An enterprise shall initially recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. • The more-likely-than-not recognition threshold is a positive assertion that an enterprise believes it is entitled to the economic benefits associated with a tax position. • The determination of whether or not a tax position has met the more-likely-than-not recognition threshold shall consider the facts, circumstances, and information available at the reporting date. More likely than not In assessing the more-likely-than-not criterion: a. It shall be presumed that the tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information. b. Technical merits of a tax position derive from sources of authorities in the tax law and their applicability to the facts and circumstances of the tax position. c. Each tax position must be evaluated without consideration of the possibility of offset or aggregation with other positions. Measurement A tax position that meets the more-likely-than- not recognition threshold shall initially and subsequently be measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. Measurement example Company C has determined that a tax position resulting in a benefit of $100 qualifies for recognition and should be measured. Management believes it is likely that it would settle for less than the full amount of the entire position when examined. Measurement example Possible estimated Probability of Cumulative outcome occurring (%) probability (%) $100 25 25 75 50 75 50 25 100 Because $75 is the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement, Company C would recognize a tax benefit in the financial statements in this amount. Measurement example Journal entries: Income taxes payable 100 Tax benefit 100 To record tax benefit claimed on the tax return. Tax benefit 25 Liability for unrecognized tax benefits 25 To reduce tax benefit to the maximum amount allowed by FIN 48. Subsequent recognition and measurement If the more-likely-than-not recognition threshold is not met in the period for which a tax position is taken or expected to be taken, an enterprise shall recognize the benefit of the tax position in the first interim period that meets any one of the following three conditions: a. The more-likely-than-not recognition threshold is met by the reporting date. b. The tax position is effectively settled through examination, negotiation, or litigation. c. The statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired Derecognition An enterprise shall derecognize a previously recognized tax position in the first period in which it is no longer more likely than not that the tax position would be sustained upon examination. Interest When the tax law requires interest to be paid on an underpayment of income taxes, an enterprise shall begin recognizing interest expense in the first period the interest would begin accruing according to the provisions of the relevant tax law. Interest The amount of interest expense to be recognized shall be computed by applying the applicable statutory rate of interest to the difference between the tax position recognized in accordance with this Interpretation and the amount previously taken or expected to be taken in a tax return. Penalties Similarly, if the company would incur penalties if the uncertain tax position were not sustained, penalties must be accrued in the first period would give rise to the penalty. Example 1 Company D has incurred $100 of costs, which have been deducted in full on its 2007 tax return and recognized as an expense for 2007. Management estimates there are three possible outcomes: 1) $100 will be allowed as a deduction in 2007 (p=.40) 2) $50 will be allowed as a deduction in 2007 with the balance amortized over 5 years (p=.40) 3) The entire $100 must be amortized over 5 years (p=.20) Example 1 In this example, the deductibility of the costs is not in question. It is simply a matter of when they will be deductible. 2007 2008 2009 2010 2011 (1) p=.40 100 0 0 0 0 (2) p=.40 60 10 10 10 10 (3) p=.20 20 20 20 20 20 Example 1 Assume a 40% tax rate. Thus, the tax benefit of this item for 2007 could be: Scenario Tax benefit (1) p=.40 $100 @ 40% = $40 (2) p=.40 $ 60 @ 40% = $24 (3) p=.20 $ 20 @ 40% = $ 8 The largest amount that is more than 50% likely is $24 (scenario 2). Therefore, Company D would recognize a tax benefit of $24. Example 1 If scenario (2) occurs, Company C will have a temporary difference: Tax basis of asset $ 40 Book basis of asset 0 Future deductible amount $ 40 Tax rate 40% Deferred tax asset $ 16 Example 1 Journal entries: Income tax payable 40 Tax benefit 40 (To record tax benefit claimed on 2007 tax return) Deferred tax asset 16 Liability for unrecognized tax benefits 16 (To recognize DTA required by FIN 48) Example 2 Company E acquired an intangible asset for $30. The asset has an indefinite life and, therefore, is not subject to amortization. For tax purposes, Company E decides to deduct the full cost in 2007 even though the tax law is ambiguous on this point. Assume a 40% tax rate applies. Example 2 Management estimates that there are three possible outcomes: 1) $30 will be allowed as a deduction in 2007 (p=.30) 2) The asset must be amortized straight-line over 3 years (p=.30) 3) The cost of the asset is not deductible in any period (p=.40) Example 2 The possible patterns of deductions are as follows: 2007 2008 2009 (1) p=.30 30 0 0 (2) p=.30 10 10 10 (3) p=.40 0 0 0 Example 2 The possible amounts of tax benefit for 2007 are as follows: Scenario Tax benefit (1) p=.30 $30 @ 40% = $12 (2) p=.30 $10 @ 40% = $ 4 (3) p=.40 0 The largest amount that is more than 50% likely is $4 (scenario 2). Therefore, Company E would recognize a tax benefit of $ 4. Example 2 If scenario (2) occurs, Company D will have a temporary difference: Tax basis of asset $ 20 Book basis of asset 30 Future taxable amount $ 10 Tax rate 40% Deferred tax liability $ 4 Example 2 Journal entries: Income taxes payable 12 Tax benefit 12 (To record tax benefit claimed on 2007 tax return) Tax benefit 8 Deferred tax liability 4 Liability for unrecognized tax benefits 4 (To adjust tax benefit to maximum allowed under FIN 48) Example 2a Suppose that in 2008, a court case resolves the uncertainty regarding this type of asset: the court finds that it is not deductible in any year. The tax position recognized in 2007 must be derecognized in 2008. Example 2a Journal entry: Tax benefit 4 Deferred tax liability 4 Liability for unrecognized tax benefits 4 Income taxes payable 12 (To derecognize tax position taken in 2007) Disclosures Companies are required to provide a reconciliation of the beginning and ending amount of unrecognized tax benefits. This one is from Merck’s 2007 annual report: 2007 ($millions) Balance as of January 1 $ 5,008.4 Additions related to prior year positions 187.8 Reductions for tax positions of prior years (87.0) Additions related to current year positions 284.5 Settlements (1,703.5) Lapse of statute of limitations (0.7) Balance as of December 31 $ 3,689.5 Required disclosures a. A tabular reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the period b. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate c. The total amounts of interest and penalties recognized in the statement of operations and the total amounts of interest and penalties recognized in the statement of financial position Required disclosures d. For positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months of the reporting date: 1) The nature of the uncertainty 2) The nature of the event that could occur in the next 12 months that would cause the change 3) An estimate of the range of the reasonably possible change or a statement that an estimate of the range cannot be made e. A description of tax years that remain subject to examination by major tax jurisdictions.